MUNIX COMMENTARY – WEEK OF 11 January
A few weeks before Christmas, the Chancellor of the Exchequer made certain comments about the UK’s public finances which are worth reflecting on. He warned that the huge levels of debt built up as part of the fight against coronavirus could become unaffordable if there is a sudden rise in interest rates. On the latest data, public sector net debt rose by £300 billion in the first eight months of the financial year to reach £2.1 trillion at the end of November 2020. This approximates to 100% of GDP, on course for 110% by 2025 on mainstream economic forecasts. High levels of debt issuance are certainly likely in the first half of 2021, reflecting the impact of further lockdowns and a modest second recession for the UK economy.
Is such debt manageable? Clearly, the Chancellor is quite correct to say yes, assuming bond yields remain at current levels – only 0.3% for UK 10-year bonds. Debt servicing for the UK is currently the smallest as a share of revenues since the 1600s! Debt management is even easier, of course, when there is a buyer with deep pockets. Around the world, central banks are purchasing most of the issuance from governments, directly or indirectly, via QE programmes. As and when the tapering of such buying begins, perhaps in early 2022 as various US Federal Reserve governors hint, then normal demand and supply rules will re-appear.
This background helps explain the animated discussion taking place in financial markets not only about the impact of vaccinations on economic activity but also the outlook for inflation and the eventual responses from central banks. The US Treasury curve has steepened in the past fortnight, as markets priced in the likelihood of an even easier fiscal policy in the USA. So far, this has had limited effect on bond markets here in Europe. Looking ahead, however, a danger point for bond markets will appear in the summer and autumn when headline rates of inflation could begin to look rather worrying. Although spare capacity – high levels of unemployment – are likely to restrain core inflation, a series of factors – higher oil, food and commodity prices, base effects from the pandemic a year ago – could easily mean that headline inflation in many countries returns for a short period back towards 2-3% a year.
As we look forward to the vaccination programmes having an effect across the developed world in 2021, and across emerging economies into 2022, then finance ministers around the world will look on a completely different set of public debt dynamics than they could have envisaged a year ago in January 2020. If the world economy does begin to recover, and interest rates inexorably follow, then how will high levels of debt be managed?
The situation is rather similar to that seen in 2008-09 when national debt last exploded higher. History tells us that there are a variety of routes which different countries will choose. One is the Latin American route of default. Argentina has defaulted 10 times in the past two centuries. A variant of this would be cancelling the debt – on the grounds that one part of the public sector, a central bank, is owning debt issued by another part of the public sector. This needs to be handled carefully, however, if private sector debt owners think that their asset might be cancelled too. Greece came close to default but was bailed out by agreeing to become part of a larger bloc – in effect its debt is now the responsibility of the ECB and EU.
There is the economic growth option, to grow tax revenues sufficiently rapidly so that debt servicing is manageable and debt declines. The UK, USA and other OECD economies took this route in the 1950s and 1960s to cope with debt incurred as a result of the second world war. Sadly, demographics, climate change and geopolitics make this less likely unless there is a technological revolution boosting productivity significantly, Inflation is always a possibility – over time the real value of the debt is inflated away. Again, this looks unlikely unless modern monetary theory is adopted by more central banks to support future years of profligate public spending, say on green new deals.
Finance ministers could look once again at the austerity approach, which the UK adopted after 2008. The OBR has already warned that tax increases of £20-40 billion, which equate to 1-2% of GDP, would be required to deliver a current budget balance by 2025–26. Not easy politically….Last, but certainly not least, financial repression ls a common approach. Much of Europe is following the same path which Japan adopted two decades ago, of negative interest rates amidst regulations encouraging domestic investors such as banks to purchase government bonds. The losers are the wealthy and pensioners who find that their returns are not quite what they hoped for.
Indeed, all these policies towards dealing with high and growing levels of national debt lead to winners and losers, as we will explore in future articles. In the meantime, the Chancellor is quite right to watch the gilt yield every day – debt servicing is quite manageable, even for an economy undergoing the worst recession for several centuries, at today’s interest rates. Tomorrow might be another matter entirely.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making